Changing the rules of the diversification game - a pensioner's tale

Tue May 4, 2010

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For all the diversification talk between 2000 and 2008, why did all pensions, no matter their asset mix, seem to lose out equally?

By Susan Barreto

Diversification isn't what it used to be. The basic concept of diversification, the putting of money to work in as many asset classes as possible to dampen the overall portfolio risk, seems to have done a negligible job in saving pension funds from going broke.

But for all the diversification talk between 2000 and 2008, why did all pensions, no matter their asset mix, seem to lose out equally? Is diversification a pensioner's myth?

This is a question recently raised in Steven Drobny's book called The Invisible Hands - Hedge Funds Off the Record - Rethinking Real Money. Drobny, well known for his interviews of global macro hedge fund managers, decided in the final chapter of his new book to interview a pension manager.

Anonymously, "The Pensioner" in Drobny's book claims that 2008 showed how the classic mix of 60% stocks and 40% bonds was akin to significant equity exposure and even the alternative investment "non-equity" assets turned out to be very equity-like in their behaviour.

The reaction to the equity overload prior to 2008 has broadly translated into a decrease in equity investments and a boost to the alternatives portfolio. A recent example of this can be found at the New Jersey Division of Investment (page 9).

Meanwhile, North Carolina is trying to decide if diversification is worth it if the allocation is small (page 8). According to consultant Ennis Knupp, further analysis regarding the optimal use of hedge funds, and documenting their use in the investment policy, would benefit the North Carolina Retirement System.

Was it only slight of hand, or are pension executives actually finding the prize in the asset management shell game that began in 2008? Has it really taken until 2010 for pension funds to move to remedy the unforeseen illiquidity, market correlation and group think strategies that caught them so off guard in 2008?

The discussions in New Jersey and North Carolina are what we have traditionally seen as pensions find their funding status improve in rising markets - or a proactive rebalancing if you will.

But the next step is much more daring and is akin to picking up all the shells in the game to find money under all three to the delight of the gambler.

So-called 'risk parity leverage' seems to have found a following among a growing group of US public pension plans. For example, the Ohio Police and Pension Fund portfolio will be levered 1.2 times, which is expected to reduce risk by 91 basis points.

So, maybe leverage is now equal to diversification of old as the way to cure an ailing portfolio?

Leverage can be used to improve the diversification of a smaller pension portfolio by levering up low-volatility assets and levering down the risky assets. The caveat is that the pension programme needs to significantly improve the risk management system for it to really reduce risk. Remember, risk measurement is not risk management - whatever anyone tells you.

In the words of Drobny's Pensioner: "The difference in expected return at the same level of risk between the levered diversified and unlevered undiversified portfolios can be substantial, potentially 2% per annum under realistic assumptions."

The argument goes that portfolios that are diversified and unlevered will increasingly fall behind too. The ability of all pension plans to employ such an approach is hindered by the public's perception of the role of leverage and derivatives in the 2008 crisis, and it remains to be seen whether a new model of diversification will cure the global pension fund crisis.

There is no doubt though that going forward modern pensioners must include at the very least hedge funds in the optimal asset mix.

ISSN: 2151-1845 / CDC10004H

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